What is the Morningstar Stewardship Rating?

Christine St Anne | 15/10/2015

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What is the Morningstar Stewardship Rating?

Mathew Hodge: So that's our take on how well management basically allocates capital. That's a key to a stewardship rating. So, if we think that stewardship is exemplary, we think the management team makes good investments, their approach to dividends is in shareholders' interest and the right thing to do, that they pay the right price when they make acquisitions or investments and that they are making investments that widen the moat.

Poor stewardship, by contrast, we think management has a tendency to overpay or to move into areas that don't have an economic moat or unlikely to improve their economic moat and could in fact detract from that or from value and their allocation between investment and dividends might not be in shareholders' best interest as well.

There are seven key things that we look at.

Investment strategy. So, other things that the managers are investing in building their competitive advantage. There is also price. So when they make that investment are they buying it at a good price. And those two things are independent of each other. Execution. So, do they run the business well or is it likely to expect problems to come up which could impact shareholder value. Dividends and Buy Back. So, have they got the mix right between investing in the business and returning money to shareholders and I guess you could argue that the resource companies through the boom got that mix very wrong. They invested too much in the business and didn't return enough to shareholders. They are probably the main things.

But then there's also financial leverage.  Is the balance sheet strong or appropriate or is it under-levered, something like an infrastructure stock can handle a fair amount of debt and that can be in equity shareholders' favor because the cash flows are fairly stable.

Management incentives. We would really only call that out if the payment was egregious. Take Berkshire, for example. Warren Buffet basically gets his income from owning the shares rather than the salary which is very modest.

Ownership structure. So, sometimes you might have a majority shareholder which is highly influential or even large shareholders can be highly influential and they may not act in the best interest of small shareholders. So, those are the seven things that we evaluate when looking at stewardship.

How does Morningstar approach stewardship?

The individual analyst has a huge bearing on the rating. They are the ones that come up with the idea, the thesis on what the stewardship should be, but then it has to be approved by their sector head or their superior and if there is contentious, it could get thrown open to the wider group. So, it largely comes from the analyst but there is also an oversight and if required then further opinions are gathered as well.

How can investors use the stewardship rating?

Probably the poor ratings are pretty useful in terms of stocks that you probably should avoid and if you think we've had poor stewardship ratings on the steel companies for quite a while and that's been fairly useful, it acknowledges that the companies in the past have made poor investments and that that would like to continue and that's basically what happened; they have made bad investments and that's destroyed shareholder value. But if you look at something like Wesfarmers which has an exemplary rating, they've got a long track record of making very good investments which are in shareholders' favor, build the moat, funding has been excellent. Coles, they paid too much and are a little unlucky to get caught in the GFC and I think that's the kind of the one blemish. But I think that was a big transformational acquisition and you could probably argue that in the long run it's going to be definitely positive for shareholders and the capital that it generates to allow them to reinvest is going to be a good thing.

This report appeared on www.morningstar.com.au 2021 Morningstar Australasia Pty Limited

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